The credit crunch started in the subprime market, but it seems that nowadays
it’s most visible, and most problematic, in the money market.
The contagion mechanism is the ABCP market: asset-backed commercial paper.
ABCP came into existence to help quench a global thirst for liquidity; now that
anything asset-backed is looked upon with suspicion, ABCP is untouchable and
can’t be rolled over. As a result, banks have to backstop their CP clients,
which means that they need their money and don’t want to lend it out. And interest
rates in the overnight to one month end of the curve are almost a full percentage
point higher than where one would expect them to be given the Fed funds rate.
Clearly, a large spread between Fed funds and Libor is not normal, and not
in the slightest bit healthy. But is there a good policy response to this nasty
gumming-up of the financial gears, and if so, what is it?
In the blue corner, we have David
Gaffen and Yves
Smith, saying that rate cuts won’t help bring down the spread between Llibor
and Fed funds. In the red corner, we have Brad
DeLong and (strange bedfellow alert!) Larry
Kudlow, saying that rate cuts are the only tool we’ve got right now, so
we might at least try them to see if they work.
I’m generally sympathetic with the red corner: extra liquidity can
breed confidence (although there’s no guarantee it will), and right
now I don’t think that inflation pressures are so great that the Fed can’t afford
a rate cut.
On the other hand, Stein’s Law says that if something cannot go on forever,
it will stop – which means that somehow the financial system
will get to a point where the spread between Fed funds and Libor will come back
down to single digits. If that’s true, then the Fed just decide to let the system
work itself out, so long as credit-sector indigestion isn’t about to devastate
the real economy.
And then there’s the question of how much the Fed should cut rates. DeLong
writes:
We may indeed need a combination of fiscal stimulus and regulatory reform.
But why not first push on the string? Maybe the string is rigid, and pushing
on it will work.
But what happens if pushing on the string doesn’t work? Do you give up, and
decide it just isn’t working, or do you conclude that you haven’t pushed enough?
Kudlow wants Fed funds "around 4 percent," which means that he’ll
continue calling for further cuts even if the Fed slashes by 100bp at the next
meeting (which I very much doubt it’ll do).
Ultimately, I’m on the rate-cutters’ side. While the spread between Fed funds
and Libor is important, the absolute level of Libor is if anything even more
important. And that is certain to come down after a rate cut, even if the spread
doesn’t change at all.